Second Quarter 2004 Conference Call Transcript

SECOND QUARTER 2004 CONFERENCE CALL

Joseph Cross, President and CEO

Welcome to the Nanophase conference call to review the second quarter for 2004. Jess Jankowski, chief financial officer, and I will be hosting this session.
To begin the review, Jess will summarize the financial highlights. After which, I will return to discuss the second quarter and provide a brief overview of certain business and market development initiatives.
Jess, would you please begin the financial review?

Jess Jankowski, Chief Financial Officer

Good morning and thank you for your continuing interest in Nanophase. As I review the financial performance of the Company for the first six months, and the second quarter, I intend to only address significant financial areas comparing 2004 versus 2003. All numbers will be in approximate terms for ease of discussion.
Total revenues for the second quarter of 2004 were $1,540,000, up $230,000, or 18%, compared to the second quarter of 2003 and they were also up 19% sequentially compared to the first quarter of 2004.
For the six month period of 2004, total revenues were $2.84M versus $2.97M in 2003, a 4.6% decrease. To dig down a little bit, for the same the six-month period, Other Revenue was up $80,000. This increase in Other Revenue, when compared to the first half of 2003, related to the first two quarterly payments, totaling $300,000, in technology development funding from Rohm & Haas Electronic Materials, offset by the sale last year of a PVS reactor to C.I. Kasei, our Japanese licensee. This funding from Rohm & Haas is part of its $600,000 commitment in 2004 to support Nanophase’s efforts in jointly developing slurry products for current and future semiconductor technologies. Ignoring the sale of the PVS reactor to our Japanese licensee in Q1 of 2003 for $226,000, which was essentially an irregular event, total revenue would have grown by 3% over the same period.
For the six month period, product Revenue was down 8%, to $2.4M, compared to the first half of last year. Sales of sunscreen and personal care materials were above expectations, and up 9% relative to the first half of 2003.
The negative fluctuation that has inhibited growth in product sales relates to CMP materials, which were down more than $400,000 between the two six-month periods. Rohm & Haas Electronic Materials’ product purchases are down in 2004 as they continue to reduce inventories of our nanomaterial dispersions shipped in 2003. This reduction has been largely offset in Other Revenue by the previously discussed technology development revenue in this period.
At current revenue levels, with the contribution from Other Revenue, we have generated a modest positive gross margin. Gross margins continue to be negatively impacted by not having enough volume, and associated revenue, to absorb the manufacturing overhead required to work with the customers we have and those we expect to attract. A large part of this infrastructure cost involves depreciation, quality systems designed for ISO 9000:2000 and cGMP compliance, and full compliance with FDA and USP standards for sunscreen materials, as well as EPA and other governmental regulations.
In example, for the six months ended June 30, 2004, depreciation relating to the operations group, including manufacturing and quality, amounted to $500,000, or about 19% of our cost of revenue. As we have stated before, Nanophase’s existing manufacturing infrastructure can support a multiple of current volume without significant overhead or infrastructure augmentation. This means that we expect growing variable margins to drive the expansion of gross margin, and our financial models show that this will occur as volume grows.
In total, the Company lost $0.08/share this quarter versus $0.10/share for the same quarter last year and $0.17/share for the first six months of this year versus $0.20/share for the same period in 2003. Note that depreciation and amortization amounted to about $0.04 cents per share, or $700,000, of the Company’s loss for the first half of 2004.
Moving to the balance sheet, Nanophase ended the first half with $13.8 million in cash and investments compared to about $5 million at the end of 2003. This increase was primarily related to the $10M equity investment from Altana in March of this year and $1.4M in proceeds from stock option exercises, over 90% of which were from non-current employees. Note that the $10.4 million increase in additional paid-in capital reflects these inflows as well, net of offering costs.
Looking at A/R, less than two percent of our $770,000 balance is past due. Eighty-five percent of the total is made up of receivables from our three largest customers: BASF, Rohm and Haas Electronic Materials, and C.I. Kasei. These same customers accounted for 74%, 12% and 6% of our first half 2004 revenue, respectively.
As you can see, inventory balances have decreased by 9% to $766,000. Given the Company’s Lean Manufacturing discipline, it’s a priority to keep inventory levels as low as possible while maintaining the capability to respond to requests for material volumes beyond what has been planned.
This balance may fluctuate based upon product revenue mix, materials lead times, and the overall economics of batch production of various materials. Management continues to minimize required working capital by holding inventory to a practical minimum.
Equipment and leasehold improvements for the first quarter of 2004 amounted to only $110,000, bringing the total balance, net of accumulated depreciation, to $7.6 million. Most of the current equipment and leasehold improvements on the balance sheet were built during the period from the latter part of 2000 through mid - 2002.
The Company expects that its known capital needs for 2004 will be somewhat greater than the $220,000 that was spent for all of ’03, but at this point unknown factors, including current and future customer demand, make an exact amount of anticipated capital need difficult to determine.
On the liabilities side, adding the current and long-term debt and lease obligations together, the Company has about $870,000 in total debt. Approximately 80% of this represents the note in favor of our largest customer for equipment to produce sunscreen nanomaterials, which, you may recall, we pay back on a per kilogram shipped basis. Most of the remaining balance relates to financed business insurance premiums.
Thank you for your attention, now I'd like to turn things back over to our CEO, Joe Cross.

Joseph Cross, President and CEO

Thank you, Jess. Since we are about half way through 2004, I would like to accomplish two general objectives in today’s discussion: first, comment on progress during the first half of 2004; and, secondly, discuss Nanophase’s general progress and some tactical objectives for the second half of 2004 and 2005.
Addressing the second quarter and first half of 2004, we believe that Nanophase made solid and definitive progress in its business development initiatives directed to revenue growth. Our efforts are specifically focused on revenue growth for 2005-2006 targeting the twin goals of reaching break-even and thereafter achieving sustainable profitability. In parallel, the Company continues to make substantial progress further developing its platform of nanomaterial technologies, adding to its technology and intellectual property estate, and, we believe, increasing the Company’s lead in nanomaterials technology.
Considering intellectual property, which represents significant value for the Company and its stockholders, Nanophase filed two additional provisional patents during the first half of 2004 and had one patent granted. The first provisional patent was discussed in the last conference call; the second provisional patent was recently filed in conjunction with ALTANA and describes a method to obtain enhanced scratch and abrasion resistance using nanoparticles in coatings. The Company now has 25 US patents and patent applications and 41 foreign patents and patent applications. Since 2000, Nanophase has grown its US patent portfolio by approximately 150%.
- As you may remember, during the last conference call, we noted that an unidentified company had requested that the US Patent Office re-examine Nanophase’s most recently granted patent that covers certain aspects of the NanoArc™ synthesis process. After the conference call, note that I said after the conference call, Nanophase management was notified that the Patent Office had agreed to re-examine the patent. Since that time, Nanophase has filed its comprehensive response to the Patent Office. The re-examination process is lengthy and could take around a year to conclude. Until resolution is reached, the patent that was granted remains issued and valid. We remain confident that during the re-examination process, the original patent will be reaffirmed largely intact.
- We understand that there has been quite a bit of speculation on this matter among some of our investors. However, management believes that the re-examination is not in any respects a credible challenge to the legal protection of our NanoArc™ synthesis technology or the underlying proprietary technology, which is definitely the larger and more significant of the two. We continue to view this re-examination request as an ineffective competitive tactic. Management also suspects that Nanophase, largely due to its technology prominence in the nanomaterials field, may be subject to this same tactic on issued patents in the future. We remain confident in the Company’s nanomaterials technologies, the patent process utilized by Nanophase, and will address any future challenges or re-examination petitions in a confident and aggressive manner to protect the Company’s intellectual property estate and technology in the nanomaterials field.
- Lastly, the Company still has several pending patent applications, both US and foreign. Our patent counsel believes that these may begin issuing during the remainder of 2004 and continue thereafter. The Company expects to file several additional patent applications during the remainder of 2004 and in the future. Again, management is highly cognizant of the value of intellectual property in the field and believes that the Company has an aggressive plan to continue increasing its intellectual property and taking appropriate steps to legally safeguard that property.
Now turning to business development and Nanophase’s multiple market approach relative to revenue growth, I would like to focus on progress with our current key partners and then overview status in several major market areas. Do understand that I am not covering each and every business and technical development initiative since they number over 100. I am only covering certain of the current initiatives to provide a general overview. Secondly, since this is business development in new markets and new applications, all of the situations are very dynamic and subject to change quickly. Any information I might provide today could change tomorrow and no longer be accurate. However, the examples cited do indicate the robustness and breadth of Nanophase’s current business and market development efforts directed to revenue growth.
Our recently announced partnership with ALTANA is off to a quick, aggressive, and promising start. As you may know, ALTANA AG is about a $3.5B company focused on pharmaceuticals and chemicals, primarily coating ingredients where they are an acknowledged global leader. In the coatings field, ALTANA is known as BYK Chemie; so you will hear us refer to ALTANA and BYK Chemie somewhat interchangeably. The coatings industry is a large global industry; for instance, the Chemical Market Reporter recently stated that the US alone accounts for approximately $21.2 billion in formulated coating systems. Obviously, the global market is significantly larger. ALTANA is a global supplier of coating ingredients and is focused on the higher value added end segment of this market. We believe that our partnership with ALTANA for nanomaterial applications in coatings, sealants, insulations, and nanocomposites will be a key component of the Company’s anticipated revenue growth during 2005-2006. I do not believe that I can over emphasize the importance of this partnership to Nanophase’s market penetration and revenue growth over the next 24 months.
While I stated during the last conference call that we expected initial market introduction of nanocomposite products during the second half of 2004, ALTANA has already introduced and announced two new products based on Nanophase’s nanomaterials, which they have trademarked NanoBYK. BYK Chemie is actively marketing those products globally, primarily concentrating in Europe and the Far East at the present time. These products have been well received and are already in active end customer testing in a variety of applications. This quick market movement by BYK Chemie demonstrates the value of the ALTANA partnership to Nanophase – global sales and distribution of nanomaterials by an acknowledged industry leader. Nanophase has shipped initial orders of nanomaterials to BYK Chemie and expects continuing orders throughout the remainder of 2004. We also expect additional BYK Chemie and ALTANA product introductions and announcements during the remainder of 2004.
Relative to the personal care market, which we believe is and will be a major growth market for nanomaterials, Nanophase has significantly enlarged its market penetration efforts along multiple fronts during 2004 that, again, are focused on revenue growth for 2005-2006.
- First, we have a solid partnership with BASF for sunscreens and certain new personal care product development. The sunscreen market growth continues to be promising: our customer’s annual order for 2004 was recently increased by 13%. Simultaneously, the new nanomaterial sunscreen formulation is proceeding well and is on schedule. We have begun manufacturing scale-up and plan to ship initial quantities by the end of the year. Certainly, we expect the new nanomaterial sunscreen formulation to positively impact revenues in 2005. In a separate, but parallel path, the personal care product development continues as planned with our partner expecting market introduction in early 2005.
- Secondly, we have entered a joint development agreement, as announced by Huber Engineered Materials, to develop certain personal care products that are outside of our partnership with BASF. Huber is a $1B+ private company and a major supplier to the personal care market. That development has started with the intent of developing one product toward the end of 2004 and another during 2005.
- Thirdly, we are now in active product development with multiple personal care Fortune 100 companies in a variety of product application areas. This is an area that has seen a great deal of effort and movement just during 2004, and is promising for potential revenue growth during 2005-2006.
Moving to the fine polishing market, this by our definition is composed of semiconductors, hard disk drives, fine optics and photomasks listed in descending market value, with semiconductor polishing making up the bulk of the market size. As a recent Chemical Market Reporter article noted, “Driven by the healthy semiconductor market and boosted by further miniaturization, strong growth is projected for CMP (that is slurry for semiconductors).” John Roberts of Buckingham Research notes that CMP has only penetrated a small fraction of the market that the technology could ultimately address. He notes that while wafers with 0.25 micron features typically have 10 CMP polishing steps, wafers with 10 micron feature sizes require up to 23 CMP polishing steps. Buckingham expects feature sizes under 0.25 micron to be about 50% of wafer production in 2005. After a severe semiconductor downturn in 2001, the global CMP semiconductor market rebounded to $425M in 2003 and is expected to reach $650M by 2006 and $804M in 2007. Again, this data is from the Chemical Market Reporter.
Our partner in the semiconductor market is Rohm & Haas Electronic Materials, RHEM, formerly Rodel, which currently holds a dominant global market share in semiconductor polishing pads and conditioners and a sizable position in silica slurries. RHEM is making definitive progress penetrating a difficult and increasingly demanding market. RHEM’s global efforts remain focused on STI and SON technologies in the US, Europe, and Asia with approximately 19 semiconductor fabs in various levels of testing and trials. RHEM’s current product is demonstrating extraordinarily low defectivity, high selectivity, and good planarity relative to competitive products. As feature sizes become smaller and wafers become larger, defects that could have been tolerated in the past are not acceptable today. We continue to be optimistic and positive about RHEM’s ability to penetrate this market and become an increasing important revenue source for Nanophase in 2005 and thereafter.
Since our last conference call, we have begun initial development of a nanomaterial-based CMP product for the bare cooper segment of semiconductors. Again according to the Chemical Market Reporter, copper is projected to be the big driver in the CMP market for the foreseeable future. Since this development has some technical challenges, we expect the efforts to continue for at least the remainder of 2004.
In hard disk drive substrates composed of glass/ceramic compositions for the next generation, we continue to make definitive progress in co-development of a CMP solution outside of our relationship with RHEM with a market-leading manufacturer.
We believe that we have now successfully passed development testing and the manufacturer is now in the process of defining a POR, or process of record, for manufacturing usage. Based on the customer’s information, we currently expect this application to begin adding potential revenue during 2005.
In fine optics polishing, business and CMP development continues to be positive. A leading manufacturer of polishing equipment for optics is standardizing on the Company’s nanomaterial dispersion as the polishing media of choice and is in the process of converting all of their lines of equipment during this summer. Additionally, a manufacturer of high quality lenses has also standardized on a Nanophase nanomaterial dispersion and is now a valued customer. Other fine optics polishing applications continue in development.
In summary, we continue to believe that the fine polishing markets, notably semiconductor CMP, potentially represents significant future revenue growth areas for Nanophase for 2005 and thereafter.
In other key target markets, business and technical development has continued to make measurable progress.
- In the catalysts area, Nanophase continues to focus on the catalytic converter segment of the market with a major automotive OEM, which is now in second round testing, and a major catalytic market supplier which is in co-development project with the Company. Assuming that development efforts continue to be successful, we believe that this area represents a significant revenue opportunity for Nanophase over the next 24-36 months. Continuing the catalysts discussion, Nanophase is beginning to develop the catalyst market for chemical manufacturing and will be focusing on this segment during the second half of 2004 and 2005.
- In an application area that is difficult to categorize, and one which we are not at liberty to publicly explain, we have made quite significant progress. For the purposes of this discussion, let me refer to it as a personal care textile application series. There have been two product developments.
- In another new application area that we similarly are not at liberty to define, Nanophase has made significant progress in the last six months. We believe that this could eventually be a multimillion dollar annual revenue opportunity for the Company. The customer has informed us that it plans to place its initial order in the near future and, if indeed that happens, we expect revenues to begin during the fourth quarter and be in full production during 2005. This represents a potentially significant revenue opportunity for the Company and, equally as positive, opens further horizontal marketing and sales opportunities in similar applications.
- Lastly, during the next 30-60 days, Nanophase intends to introduce its NanoExpress™ concept to its markets. Understand that the conundrum we and others in nanotechnology often face is that the value of nanomaterial in an application is not known until it is tested empirically in an application. A further fact is that nanomaterials produced under laboratory conditions rarely, if ever, have the same properties as those produced in a production environment. It is for this reason that Nanophase develops new nanomaterials in production systems.
  NanoExpress™ is a commercial scale NanoArc™ synthesis manufacturing system that is specifically designed to be able to make smaller lots economically. At this point in time, we are having market, not technical, pull for new nanomaterials from a variety of markets and need the capability to develop new nanomaterials at reasonable, but not large-scale, volumes. NanoExpress™ is designed to accomplish just that. Strategically, NanoExpress™ should reduce the time-to-market for new nanomaterials and application testing, which, we believe, should lead to faster revenue growth. Again, we expect to launch NanoExpress™ within the next 30-60 days.
Turning briefly to operations, we continue to pursue our plans in six sigma Lean Manufacturing and we believe that the Company is achieving excellent results in this regard.
- Nanophase is completing its plans to increase PVS reactor output by 20-30% for volume products without capital costs. Ignoring facility cost, the Company is adding PVS capability equivalent to almost $1 million of current reactor capacity and output for little to no capital investment. Since we began focused process improvement in late 1999, we have increased PVS reactor output almost 8 times the initial rates.
- The Company has completed implementation of work cell re-engineering in Burr Ridge that reduces reactor labor requirements by about 25%. To put this in perspective, since Nanophase began instituting its state-of-the-art manufacturing practices in 1999, we have now reduced labor content and cost per reactor by a cumulative total of over 80%.
- Nanophase’s production quality and customer service continue to be excellent. YTD in 2004, we have had no defective material reported shipped to our customers and have shipped every order on time.
- We have also added manufacturing personnel, principally at the Burr Ridge site, to increase the number of production shifts preparing for planned higher production levels during the second half of 2004 and into 2005.
In summary, the Company’s drive to grow revenues toward first break-even and then profitability is proceeding and gathering momentum. Our business and technical development initiatives are robust, cover an increasing breadth of markets, are now active on three continents, and the opportunities have continued to grow during 2004. Management firmly believes that its business and technical development initiatives will advance the Company’s revenue growth goals and corresponding financial performance.
That concludes our prepared remarks and we are ready for questions at this time.